Contemporary Investments: Chapter 9 Chapter 9 FIXED INCOME SECURITIES: VALUATION AND RISKS Why are...
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Transcript of Contemporary Investments: Chapter 9 Chapter 9 FIXED INCOME SECURITIES: VALUATION AND RISKS Why are...
Chapter 9 FIXED INCOME SECURITIES:
VALUATION AND RISKS• Why are bonds viable investment
alternatives?• What are the risks faced by bond
investors?• How bonds are priced?• What are the basic bond pricing
theorems?• How can interest rate risk be measured?• How can credit risk be evaluated?• How are bond risk and required return
related?
Why bonds?
• Income
• Potential for capital gains
• Paper versus real losses
• Diversification
• Tax advantages
Figure 9.1 – Yield on Long-Term Treasury Bonds vs. the Dividend Yield from the S&P500
Risks associated with investing in bonds
• Credit risk• Interest rate risk • Reinvestment risk• Purchasing power risk• Call risk• Liquidity risk• Foreign exchange risk
Bond valuation
• Basics of bond pricing– Identifying the bond’s cash flows
– Bond price is present value of its cash flows
– Semiannual coupons
– Accrued interest
Bond valuation – Cont.
• Yield-to-maturity
• Relationship between coupon rate and yield to maturity
• Current yield
• Yield to call
• Actual return versus yield to maturity
Figure 9.2 - Reinvestment Rate and the Actual Rate of Return for a Bond
Five bond pricing theorems• Bond prices move inversely to changes in
interest rates• Bonds with longer maturities are more price
sensitive• Price sensitivity increases at a decreasing
rate• Bonds with lower coupon rates are more
price sensitive• A price increase caused by a decrease in
interest rates is larger than a price decrease caused by an increase in interest rates of the same magnitude
Figure 9.3 – Bond Price vs. Yield to Maturity
Figure 9.4 – Price Sensitivity and Maturity
Figure 9.5 – Price Sensitivity and Coupon Rate
Figure 9.6 – Price Changes for Increase and Decrease in Yield
Assessing interest rate risk
• What is duration?
• Finding a bond’s duration
• Duration and price sensitivity
• Duration and price changes
Figure 9.7 – Relationship Between Duration and Maturity
Figure 9.8 – Relationship Between Duration and Coupon Rate
Figure 9.9 – Relationship Between Duration and Yield to Maturity
Credit risk
• Bond ratings– Description of bond ratings– Determinants of bond ratings– Bond ratings and default rates– Graham & Dodd on credit risk and bond
selection
Risk and required return for bonds
• General relationship (equation 9.8) r = f (i, ∆p, ir, rr, dr, cr, lr, fxr)
• Bond yields and maturity
• Bond yields and credit risk
Figure 9.10 – Yield Spread Between T-Bonds and T-Bills
Figure 9.11 – Quality Yield Spreads in the U.S. Capital Markets